This article is an excerpt from the 2020 edition of The Art of Tendering: A Global Due Diligence Guide, which is available for purchase.
In its August 2019 report entitled Guided Missile Frigate, the U.S. Government Accountability Office (GAO) took issue with the Navy’s plan to purchase a $20 billion fleet of billion-dollar frigates on terms that limited the contractor’s responsibility for post-delivery defects to $5 million per ship, or 0.5 percent of the purchase price, finding that this strategy shifted far too much risk to the government.
As the report stated, the Navy rejected the use of warranties for its new ships since it feared that this would limit the number of suppliers who would bid on its Littoral Combat Ship program, a $20 billion program for the construction of 20 new frigates:
The Navy also plans to require that each ship has a minimum guaranty of $5 million to correct shipbuilder-responsible defects identified in the 18 months following ship delivery. However, Navy officials discounted the potential use of a warranty—another mechanism to address the correction of shipbuilder defects—stating that their use could negatively affect shipbuilding cost and reduce competition for the contract award.
However, as the GAO observed, the Navy provided no analysis to support this no-warranty decision:
The Navy provided no analysis to support these claims and has not demonstrated why the use of warranties is not a viable option. The Navy’s planned use of guarantees helps ensure the FFG(X) shipbuilder is responsible for correcting defects up to a point, but guarantees generally do not provide the same level of coverage as warranties.
As the report explained, once the limited contractual coverage is exhausted, the limited guarantee would shift the risk of post-delivery defects onto the government:
During the guaranty period, the shipbuilder would be required to correct all defects for which it is responsible, with proposals required to include a minimum limitation of liability of $5 million per ship. Once the total cost to correct identified defects reaches $5 million, the government would pay the full cost to correct any additional guaranty period defects.
In fact, the GAO referred to its prior March 2016 report where it found that the use of limited dollar guarantees “did not help improve cost or quality outcomes for the ships reviewed” while the use of warranties improved “cost and quality outcomes by requiring the shipbuilders to pay to repair defects”. As the August 2019 GAO report detailed, warranties have a far better track record, when compared to limited guarantees, of improving cost-controls and quality outcomes:
We found in March 2016 that the use of a guaranty did not help improve cost or quality outcomes for the Navy and Coast Guard ships we reviewed. We also found that commercial ship buyers and Coast Guard officials stated that warranties foster quality performance because the shipbuilder’s profit erodes as it spends money to correct deficiencies after delivery, during the warranty period.42 We further reported that the Coast Guard has improved cost and quality by requiring the shipbuilder to pay to repair defects by following Federal Acquisition Regulation warranty provisions. For example, the Coast Guard paid up front for the Fast Response Cutter warranty. The cost of the warranty amounted to 41 percent of the total defect correction costs. Although this ship does not have the size and advanced systems planned for FFG(X), it serves to demonstrate the potential value to the government presented by the use of warranties. The Coast Guard also used a fixed-price incentive contract with a warranty on its Offshore Patrol Cutter—a ship of comparable size to FFG(X). The first Offshore Patrol Cutter has a 2-year warranty, and follow-on ships will have 1-year warranties. The Coast Guard pays a set amount for these warranties, and in return, the shipbuilder must fix all applicable defects identified within the agreed-upon time period regardless of cost.
The GAO also noted that the upcoming frigate RFP offered the Navy “an opportunity to solicit pricing for a warranty to assess the cost-effectiveness of the different mechanisms to address ship defects.” Furthermore, while warranties are not mandatory under US federal procurement rules, the GAO observed that those rules instruct contracting officers to consider the use of warranties when it is practical and cost-effective to do so:
Rather than using guarantees for the FFG(X) contract to provide for the correction of defects, the Navy could help control costs to the government through the use of warranties. Under warranties, the government generally receives a contractual right for the correction of all defects for which the shipbuilder is responsible at the shipbuilder’s expense. The use of warranties is typically not mandatory, but federal and defense acquisition regulations instruct contracting officers to consider various factors when deciding whether a warranty is appropriate for an acquisition. The regulations also instruct contracting officers to use a warranty when it is practicable and cost-effective to do so. We previously found that, unlike a warranty, the Navy almost exclusively paid for defects that were the shipbuilder’s responsibility under a guaranty because of the contract type and terms in contracts that we reviewed. Such conditions limit the incentive to discover every deficiency during the guaranty period, and may negatively affect quality improvements over time.
In summary, rather than prematurely rejecting the use of warranties, the GAO concluded that the Navy should seek bids that include warranty offers so that the government can make an informed decision regarding the cost-effectiveness of its warranty and no-warranty options:
The Navy’s FFG(X) plans suggest that the Navy may be prematurely discounting warrantees as a mechanism to improve ship quality and decrease cost to the government. Navy officials told us that mandating that industry propose a warranty could result in additional costs to the government because the initial cost of the ship could be raised substantially to include the cost of the warranty. Additionally, Navy officials said a requirement for warranty pricing could serve to limit industry participation in the FFG(X) competition if offerors are unwilling to accept the risk associated with a warranty and unable to provide reasonable pricing. The Navy provided no analysis to support these claims and confirm a clear understanding of whether a warranty could provide greater value than the $5 million guaranty the Navy is proposing for FFG(X).
As part of the competitive proposal process for FFG(X) detail design and construction, the Navy could maintain its plans to require a guaranty but also seek ship warranty pricing. The full and open competition for the FFG(X) contract award may increase the potential for receiving warranty pricing that provides a cost-effective alternative to the Navy’s guaranty plans. By limiting the request for proposal to guarantees, the Navy misses an opportunity to obtain information on what comprehensive warranty coverage against defects would cost, and use it to evaluate whether warranties could further reduce risk for the FFG(X) program.
As this case study illustrates, project teams should carefully consider the post-delivery risks associated with their major long-term acquisitions. While purchasing institutions should avoid “over-insuring” when buying standard low-risk items, since this tends to artificially inflate contract costs and discourage competition, that same logic does not automatically apply to major long-term procurements involving complex technologies and protracted design and delivery schedules. When dealing with complex, long-term acquisitions, government institutions should develop cost-control strategies that include clearly defined specifications and carefully drafted warranties that keep suppliers accountable for post-delivery defects.
